When a debtor files for bankruptcy, every transaction that occurred in the months leading up to the filing is subject to scrutiny. The court and the bankruptcy trustee are tasked with determining whether any of those transactions unfairly benefited one creditor over another. When that happens, the payment or transfer is known as a preferential transfer.
For creditors, understanding what constitutes a preferential transfer is essential. It can determine whether a payment you received from a debtor before bankruptcy must be returned to the estate, even if the payment was made in good faith.
This guide explains what preferential transfers are, how they work under the Bankruptcy Code, what exceptions exist, and how creditors can defend themselves when facing a trustee’s demand for repayment.
Understanding Preferential Transfers
A preferential transfer occurs when a debtor, before filing for bankruptcy, transfers property or makes a payment that favors one creditor over others. The goal of bankruptcy law is to ensure that all creditors are treated fairly and that no one receives an advantage based on timing, insider relationships, or selective payments.
The legal authority for preferential transfers is found in Section 547 of the U.S. Bankruptcy Code (11 U.S.C. § 547). This section allows the trustee to recover certain payments made by the debtor to creditors during a specific period before filing for bankruptcy.
The idea is not to punish creditors but to promote equality. Without this rule, struggling debtors might selectively pay certain creditors—often family members, insiders, or particularly aggressive collectors—while leaving others unpaid. By recovering preferential payments, the bankruptcy system restores fairness among all creditors.
The Legal Elements of a Preferential Transfer
For a trustee to successfully claim that a transfer was preferential, all six statutory elements under Section 547(b) must be met.
- A Transfer of the Debtor’s Property
There must be an actual transfer of the debtor’s property, which could include cash, checks, goods, services, or security interests. Even granting a lien can qualify as a transfer because it changes the distribution of the debtor’s assets. - To or for the Benefit of a Creditor
The transfer must benefit a creditor or an entity that has a claim against the debtor. For example, if the debtor pays a supplier’s invoice, that supplier is the beneficiary of the transfer. - For or on Account of an Antecedent Debt
The transfer must be made on account of a debt that existed before the payment was made. This means the payment was for an already-existing obligation, such as a past-due invoice or loan payment. - Made While the Debtor Was Insolvent
The debtor must have been insolvent at the time of the transfer. Under the Bankruptcy Code, a debtor is presumed insolvent during the 90 days leading up to the bankruptcy filing. - Made Within the Preference Period
The timing of the transfer is critical:
- 90 days before the bankruptcy filing for most creditors
- One year before filing if the payment was made to an insider (such as a relative, corporate officer, or affiliate)
- That Enables the Creditor to Receive More Than It Would Under Chapter 7 Liquidation
The transfer must have improved the creditor’s position compared to what it would have received if the debtor’s assets were liquidated under Chapter 7. If the payment allowed the creditor to collect more than others, it may be considered preferential.
If all six elements are satisfied, the transfer is considered preferential, and the bankruptcy trustee may seek to undo the transaction.
Common Examples of Preferential Transfers
Preferential transfers often appear in ordinary business relationships. Many creditors are surprised when a seemingly routine payment becomes the subject of a trustee’s demand letter. Some common examples include:
- Late payments on outstanding invoices shortly before a bankruptcy filing
- Paying off a loan balance owed to an insider or friend
- Granting a security interest to a lender for a previously unsecured loan
- Pre-bankruptcy settlements with one creditor but not others
- Payment of back rent or utility bills after prolonged delinquency
Each of these situations can trigger scrutiny, particularly when the payment benefits one party over others just before bankruptcy.
The 90-Day Look-Back Period
The 90-day preference window is one of the most significant elements of preferential transfer law. During this period, the trustee reviews all payments made by the debtor to determine whether they were preferential.
For example, suppose a debtor paid your company $15,000 to settle old invoices 60 days before filing for bankruptcy. If that payment meets the elements of a preferential transfer, the trustee could demand repayment of the $15,000, even though you acted in good faith.
The rule ensures that all creditors receive equal treatment, but it can be frustrating for those who legitimately collected overdue payments before learning of the bankruptcy.
Insider Preference Period: One Year
For insiders, the look-back period extends to one year. Insiders include individuals or entities with a close relationship to the debtor, such as:
- Relatives of individual debtors
- Partners, officers, or directors of a corporate debtor
- Affiliates or entities controlled by the debtor
This extended period recognizes that insiders often have advance knowledge of financial distress and may attempt to recover their debts before a bankruptcy filing.
How Trustees Recover Preferential Transfers
When a trustee identifies a potential preferential transfer, they typically begin with a demand letter to the creditor requesting voluntary repayment. If the creditor refuses or fails to respond, the trustee may file an adversary proceeding in bankruptcy court to recover the funds.
The amount recovered becomes part of the bankruptcy estate, which is then distributed to creditors according to priority rules. This ensures equal treatment and discourages pre-bankruptcy favoritism.
Defenses to Preferential Transfer Claims
Fortunately for creditors, not every payment made before bankruptcy must be returned. Section 547(c) of the Bankruptcy Code provides several defenses that creditors can use to protect payments received. These defenses are critical for preserving what might otherwise appear to be preferential transfers.
1. The Ordinary Course of Business Defense
This defense applies when the payment was made in the ordinary course of business between the debtor and creditor. To qualify, the transaction must be consistent with the parties’ historical dealings or standard industry practices.
Examples include:
- Regular monthly payments under consistent terms
- Standard billing cycles with no unusual collection activity
- No signs of special treatment or accelerated payments
If you can show that the payment was ordinary, not extraordinary, the trustee may be unable to recover it.
2. The Contemporaneous Exchange for New Value Defense
If the transfer was intended as a contemporaneous exchange for new value, it is not considered preferential. This means the debtor provided payment at the same time it received goods or services.
Example: A supplier delivers raw materials on Monday, and the debtor pays for them immediately upon delivery. That payment is not on account of an old debt but for new value, so it is not preferential.
3. The Subsequent New Value Defense
Creditors can also defend against preference claims by proving they extended new value to the debtor after receiving the payment in question. The idea is that providing new goods or services replenished the estate, offsetting any unfair advantage.
Example: A contractor receives payment for prior work, then continues to provide additional labor or materials after the payment. The new value defense may reduce or eliminate the amount the trustee can recover.
4. Purchase Money Security Interest (PMSI)
If a creditor has a properly perfected purchase money security interest in property that was transferred, that payment may be exempt. PMSIs often arise in equipment or vehicle financing arrangements.
5. Statutory Liens and Certain Financial Contracts
Some payments made under statutory liens, margin payments, or swap agreements may be protected by specific provisions of the Bankruptcy Code.
6. De Minimis Transfers
In some cases, trustees may not pursue small or de minimis transfers because the cost of litigation outweighs the potential recovery. Although not a formal defense, practical considerations can sometimes resolve these disputes early.
How Creditors Can Respond to Preference Demands
Receiving a preference demand letter can be alarming, especially if you had no prior warning of the bankruptcy. However, it is essential to approach the situation strategically.
Step 1: Review the Trustee’s Allegations Carefully
The trustee must identify the specific payments being challenged, the amount in question, and the time frame. Compare these with your internal records to verify accuracy.
Step 2: Gather Documentation
Collect invoices, contracts, bank records, correspondence, and proof of shipment or delivery. Documentation can support defenses such as ordinary course of business or contemporaneous exchange.
Step 3: Evaluate Available Defenses
Consult experienced bankruptcy counsel to determine which statutory defenses apply. Even if a transfer technically meets the elements of a preference, strong defenses may exist.
Step 4: Negotiate Before Litigation
Many preference cases settle through negotiation. Trustees often prefer to resolve disputes without filing suit, especially when faced with credible defenses and well-documented evidence.
Step 5: Engage Experienced Counsel
Because bankruptcy preference law is complex, working with a creditors’ rights attorney can help protect your interests. A knowledgeable attorney can evaluate the trustee’s claims, prepare responses, and advocate for a fair resolution.
Why Trustees Pursue Preferences So Aggressively
From a creditor’s perspective, preference actions may seem unfair. After all, you simply received payment for what you were owed. However, the trustee has a fiduciary duty to maximize recovery for the bankruptcy estate.
Preference actions serve several purposes:
- Equal treatment: They ensure all creditors share fairly in the estate’s assets
- Transparency: They prevent favoritism toward insiders or select creditors
- Estate recovery: They expand the pool of available funds for distribution
Understanding these motivations can help creditors navigate disputes with less frustration and more strategy.
Preference Litigation: What to Expect
If negotiations fail and the trustee files a lawsuit, the process becomes an adversary proceeding within the bankruptcy case. Here’s what typically happens:
- Complaint Filed: The trustee files a complaint alleging preferential transfers
- Response Deadline: The creditor must file an answer, asserting applicable defenses
- Discovery Phase: Both sides exchange documents and testimony to support their claims
- Motions or Settlement Talks: The parties may attempt to resolve the case through summary judgment or settlement
- Trial (if necessary): If unresolved, the court determines whether the transfers are avoidable
Preference litigation can be costly and time-consuming, but with solid documentation and legal counsel, many creditors successfully defend or settle these claims favorably.
Preferential Transfers vs. Fraudulent Transfers
While the terms are sometimes used interchangeably, preferential transfers and fraudulent transfers are distinct legal concepts.
- Preferential Transfer: A legitimate payment made to a creditor that happens to favor one party over others within a specific timeframe before bankruptcy
- Fraudulent Transfer: A transfer made with intent to hinder, delay, or defraud creditors, or for less than reasonably equivalent value
Fraudulent transfer claims fall under Section 548 of the Bankruptcy Code and can reach back up to two years (or longer under state law). Trustees often evaluate both preference and fraudulent transfer theories when reviewing pre-bankruptcy transactions.
How Creditors Can Prevent Preference Exposure
While it is impossible to predict when a customer might file bankruptcy, creditors can take proactive steps to minimize risk.
1. Monitor Payment Behavior
Changes in payment habits, such as sudden lump-sum payments or shortened intervals, may signal financial distress. Keeping a consistent payment pattern can help preserve an ordinary course of business defense.
2. Use COD or Prepayment Terms
Requiring cash on delivery (COD) or prepayment for new orders reduces exposure because these transactions are contemporaneous exchanges for new value.
3. Maintain Consistent Credit Terms
Avoid special arrangements or accelerated payments for customers showing signs of trouble. Consistency is key to establishing that transactions were ordinary.
4. Perfect Security Interests Promptly
Properly perfecting liens or security interests ensures that payments related to secured debts are less vulnerable to avoidance actions.
5. Keep Thorough Records
Detailed invoices, correspondence, and delivery confirmations can make or break a defense. Documentation demonstrates that transactions were routine and legitimate.
The Role of Legal Counsel in Preference Defense
When a creditor receives a preference claim, timing and expertise matter. An experienced creditors’ rights firm can evaluate whether the trustee has met all statutory elements under Section 547(b), analyze potential defenses under Section 547(c), prepare a strategic response, and represent the creditor in adversary proceedings if litigation becomes necessary.
The earlier you involve counsel, the stronger your position becomes.
The Broader Impact on Creditors’ Rights
Preferential transfer law reflects the broader balance between debtors and creditors in bankruptcy. While it can seem burdensome to return funds you legitimately earned, it also prevents the chaos that would result if debtors selectively paid only certain creditors before filing.
By understanding how preference law works, creditors can make informed decisions, negotiate effectively, and reduce risk across their portfolios.
Moreover, firms that manage large case portfolios benefit from proactive bankruptcy monitoring. Identifying potential debtor distress early allows creditors to adjust credit terms, perfect liens, or pursue alternative collection strategies before preference issues arise.
Key Takeaways
- A preferential transfer is a payment or transfer made by a debtor before bankruptcy that benefits one creditor over others
- The look-back period is 90 days for most creditors and one year for insiders
- Trustees recover preferences to promote equal treatment among creditors
- Common defenses include ordinary course of business, contemporaneous exchange, and new value
- Creditors should gather records, analyze defenses, and seek legal counsel promptly
- Maintaining consistent payment practices and perfecting security interests can help prevent future issues
Understanding these principles empowers creditors to navigate the bankruptcy process with greater confidence and protect their right to fair treatment.
Partner with Tatman Legal to Protect Your Rights
At Tatman Legal, we help creditors navigate the complex intersection of bankruptcy law and debt recovery. Our attorneys understand how preference claims can impact your bottom line, and we are skilled in building strong defenses against trustee demands.
Whether you are responding to a demand letter, negotiating repayment, or facing litigation, we work to protect your interests efficiently and effectively. We also provide comprehensive bankruptcy monitoring and case portfolio management services to help creditors stay informed and reduce risk across multiple accounts.
If you have received notice of a preferential transfer claim or need guidance on protecting payments from avoidance, contact Tatman Legal today. Our team is ready to advocate for your rights and ensure you are treated fairly under the law.